The Quality of Private Monitoring in European Banking: Completing the Picture

Abstract

The philosophy behind the debt market discipline approach to banking regulation presumes that the pricing of bank debt securities, if accurate, conveys reliable signals to supervisors. In this paper, we take a critical look at the feasibility of such an approach by exploring empirically the possibility that markets may price differently the risk profile of bank issuers along the empirical distribution of credit spread. The paper proposes a quantile regression framework to draw novel inferences about the functioning of market discipline and the quality of private monitoring in European banking and provides a more comprehensive picture of the distribution of spreads conditional on its main explanatory factors. We find that the spread-risk relationship is systematically steeper and more significant at the "right-tail" of the conditional distribution of credit spread, which suggests that the market is somewhat tougher with "high-risk" banks.